The FSA wrote to CEOs of Asset Managers in
December to say that firms weren't always realistic about
outsourced service provider risk. They said firms would
be in real trouble should a big provider of investment operations
or transfer agency go bust. Broadly this seems fair - the
likelihood and impact of such an event could be off the scale in
most firms' risk management processes and as a result, many
firms are struggling to see a credible solution to the
regulators' concerns. The reality is that the regulator
will press this issue, and there are some subtleties that may be
worth thinking about to both satisfy the requirement and to
actually give firms an edge.

Here's what firms are currently saying:

"There's a reason the work was outsourced in
the first place". Retaining an ability to
exercise "step-in" rights or in-source the function
quickly defeats the business case for outsourcing.

"Oversight has to focus on delivery not
risk". Firms meet providers regularly and get
Management Information (MI) on service delivery. They often
skimp on risk because vendors are shy about internal operational
risk and clients can't do much about it.

"Investment firms have little
leverage". Providers are typically large global
banks. Most firms have little or no commercial leverage, so
expecting these players to adjust their operating models or to
expose internal MI is unrealistic. Even where contractual
"step in" rights exist, many people agree they're
hard to enforce.

"It's like deck chairs on the
Titanic". A provider failure would either be
caused by – or would cause - major market disruption.
Firms may stop trading after declaring a chaotic market.
Besides, our peers would be equally troubled, so there's little
competitive advantage to be gained.

"We'll club together with other
firms". These organisations have many
clients. Between us we could step in and recover.

So the argument goes that if outsourcing is effectively
prohibited, that's fine – but clients will experience
higher fees and get a less resilient service. That can't
be what the regulator wants, right? In response, the regulator
might say:

"You haven't outsourced the
risk". It's an old one but a good
one. If the new model has new risks, they need managing
– and remember the firm has chosen to be in this
situation.

"Oversight is different from risk
management". Those who monitor providers'
services are typically incentivised by service delivery, not risk
management. So this can't be about silos – the
support, assurance and risk functions need to line up around this
one.

"The business model and environment have
changed". The sector has outsourced a lot in
the last decade, and we know big providers can go 'pop'
(the regulator may be less averse to this than in the past).
There are few firms who can demonstrate an ability to deal with the
combination of those two changes.

"Limited commercial power doesn't excuse
inaction". There are still things you can do to
prepare, predict and react. Not all firms will be affected in
the same way - there may be good opportunities to harvest FUM from
failed competitors.

So where does this leave the CEOs who have to respond to this
letter? The regulator's position is likely to evolve
– but we know enough to give existing BAU and change efforts
something to think about:

Narrow responses won't work.
Vendor managers, BCP, Op Risk and others need to join up.
Solutions from each of these functions alone are likely to be
incomplete.

It's not all about the big players.
Many firms may be surprised by how a 'middle tier' of
vendors is critical. This may include smaller unregulated
firms like datacentre providers. They're more likely to
fail, get less oversight, and could create the same client outcome,
i.e. big redemptions. This is where the outsourced risk is
both credible and manageable.

It doesn't have to be reactive. Some
firms use formal 'early warning' indicators for the
financial viability of their providers. Although a rushed
in-source or switch is still unattractive, early detection could
provide valuable time to act.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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